Europe's Contagion Has Already Begun

On Tuesday, I wrote about the problems associated with mixing monetary and fiscal funds through the International Monetary Fund in an effort to prevent defaults and contagion in Europe.

On Wednesday, U.S. Treasury Secretary Timothy Geithner stated that the U.S. Federal Reserve would not be "providing" funds to the IMF. My Rorschach response was "whatever".

The mere fact that the Treasury Secretary is speaking for the Federal Reserve is an indication that big things are wrong. Up until the Lehman Brothers failure, the typical response from fiscal leaders when asked about monetary policy and vice versa was a version of "no comment". There was an unwritten rule that the Treasury Department and government leaders would not discuss monetary policy, and that the Federal Reserve board and bank members would not discuss fiscal policy.

Since rules can be altered to make any action "legal," existing restraints are meaningless. Because of this, we know that European leaders have still not decided whether or not they want to bother trying to save the union, regardless of what they say.

The longer they wait, the more difficult and expensive even making the attempt will be, and the less likely it is they will bother.

Moving on!

Regardless of what happens to the euro and the E.U., what is known is that Europe is going into a recession in 2012 that increasingly looks severe and exaggerated by its leaders' lack of conviction in handling the immediate issues.

That means that economic contagion is inevitable and imminent and will have global consequences. I will come back to discussing the European situation in the future, but for now, each column is going to be dedicated to a different thread of economic fallout.

This thread is going to discuss the Europe-China-Brazil-Japan nexus. I will follow up with more detailed columns.

China's primary export market is the E.U., which has about a 20% share. The U.S., by comparison, is a close second at close to 20%. The germane point is that a European recession in 2012 means fewer exports from China to the E.U. Because China's domestic economy is still too small to make up the difference, the Chinese have two other avenues of approach. First, theoretically, they could depreciate their currency to stimulate exports. But this would cause political problems with the U.S. and cause their cost of commodities imports to increase, so it's probably not happening. They could implement another government spending stimulus plan as they did after the collapse of Lehman Brothers. Although this will probably get done, it too is problematic.

This move would cause domestic inflationary pressures to increase, just as currency depreciation does. More importantly China is suffering the consequences of the poorly managed post-Lehman stimulus plan. At that time, the size of its government stimulus was three times that of the U.S. plan, as a percentage of GDP.

China was afraid of a recession and overstimulated its domestic economy to compensate. Although hard figures are difficult to come by with respect to China, the best estimates in the West are that 50% of the loans resulting from that stimulus are in default. Those are catastrophic losses, and they make it more difficult to implement more of the same.

It will be done, though -- just at a much smaller level than in 2008.

Most importantly, though, China will attempt to engineer a domestic slowdown, and that will mean that it too does not need to import as much from other countries.

China's biggest import is money, which is provided by the U.S. and Japan. Commodities imports come from Australia and represent 25% of that country's exports; this gave rise to the adage "as goes China, so goes Australia."

However, another country has quietly reached this same level of reliance upon exports to China: Brazil. Investors need to be mindful of the potential for "as goes China, so goes Brazil."

Brazil's growth has been one of the drivers for a dramatic increase in Japan's investments there. Many of these investments, however, are speculative in nature.

Another reason for the shift into Brazilian debt markets by Japanese investors is that the U.S. and European sovereign markets have flat yield curves.

If Brazil slows because China slows because Europe slows, the Japanese may try to exit the Brazilian financial markets to avoid losses. If they were to do this simultaneously, which is likely, they could incur losses and drive up Brazilian sovereign yields as a result.

Putting aside the impact this would have on Brazil, the most important issue we are watching for is the impact such investment losses would have on Japanese interest rates. They could signal the beginning of rising sovereign yields in Japan, which could force Japan into sovereign insolvency within less than a year.